The Thing about the Fed Most Worth Knowing

Those who think that relatively independent central banking is crucial to maintaining order in the modern world must be discouraged by the news from Washington these days.

It was the House of Representatives that this week made headlines. Its Financial Services Committee backed a provision, by a 43-26 margin, that was introduced by Texas Republican Ron Paul that would permit the Government Accountability Office, the investigative arm of Congress, to audit monetary policy and bank lending. Paul, the erstwhile Libertarian presidential candidate, is author of End the Fed. Committee chairman Barney Frank, Democrat of Massachusetts, opposes the measure. He said he expected that Paul’s proposal would be “revisited” when the bill reached the floor.

The Senate takes its turn after the Thanksgiving holiday. Confirmation hearings are scheduled for December 3 on Fed chair Ben Bernanke’s second four-year term. They’ll be as tightly choreographed as a kabuki play. Much more alarming is Sen. Christopher Dodd’s plan to take away the task of regulating commercial banks and bank holding companies from the Fed. The Connecticut Democrat, chairman of the Senate Banking Committee, is facing a tough re-election campaign.

Dodd says the Fed’s supervisory arm has done a lousy job. The proud old central bank should concentrate on the task of making monetary policy, he says – that is, setting reserve requirements and overseeing interbank lending — and leave banking supervision to a single big bank regulator. His bill would combine under one roof examiners from all four agencies that have been created over the last century to oversee disparate sectors of the industry – bank examiners from the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corp., and the Fed.

It’s a terrible idea. For one thing, the Fed depends on the bankers whom it supervises, at least the best of them, to share their inside knowledge of the industry. For another, shotgun marriages of government agencies seldom work. John Berry, the veteran Fed watcher who now writes for Reuters, put it this way last week: “This new agency would have to absorb the bank examiners of all the existing agencies at a time when the banking system is under enormous stress. New lines of authority would have to be developed, and employees would have to be transferred to new location. Confusion is far more likely than better regulation and oversight, at least for several years. If you would like a model, think of the Department of Homeland Security.”

Certainly it’s true that the Fed fumbled the job of monitoring the housing bubble, still more construing its significance. But the Securities and Exchange Commission, which regulated the Wall Street investment banks, fared far worse – it couldn’t even catch a flagrant thief like Bernard Madoff right under its nose, largely because of Madoff’s connections to the people for whom the SEC works. And that leads to a point that Bernanke cannot make publicly – probably the single most important thing to understand about the Fed. .

The Federal Reserve Board never has to ask Congress for an appropriation. Interest on the enormous portfolio of government bonds that it has accumulated over the years through open market operations is huge, $27.5 billion in 2008 – sufficient to cover its own $3.9 billion payroll. Last year it handed over to the US Treasury a total of $31.7 billion, which included earnings from various other odds and end, according to its Annual Report.

The SEC, in contrast, requires an annual budget appropriation from Congress, giving lobbyists a direct pipeline to legislators via campaign contributions, and fostering a certain degree of cautiousness among regulators. The failure to detect the Madoff Ponzi scheme was all too emblematic of the results of direct Congressional oversight.

Thus the real action is going to come next year, beginning with President Obama’s State of the Union Address. Health care legislation will be in the rear-view mirror then; deficit reduction and banking reform will lie ahead. The president’s job will be to protect the Fed from Congressional overreaching and sell the American people on comprehensive banking reform.